Next to the tax code, differential equations, and why Gilligan and the other castaways could never get off the island, annuities are really difficult to grasp. Frankly, any time you mix insurance products with investing products the result is ugly. Yet annuities can be a smart way to save for retirement and to generate income during your golden years. They can also be an expensive mistake.

For this reason, I invited Tim Holmes of Vanguard to join us on the Dough Roller Money Podcast. Tim is the principal and head of Vanguard Annuity and Insurance Services. Annuities are a dense topic, but Tim did a great job of walking us through the different types of annuities and whether they’re a good way to save for retirement and generate some guaranteed income in retirement.

Topics Covered in the Interview

  • What are the different types of annuity products
  • What is a deferred variable annuity and how does it work
  • How long must you invest in a deferred variable annuity to justify the costs
  • Should you annuitize a portion of your retirement nest egg, and if so, how much
  • How much do annuities cost
  • How do interest rates affect the cost of annuities
  • What is the difference between a joint annuity and a single annuity
  • Can annuity income adjust with inflation

Resources Mentioned in the Interview

Transcript of Interview with Tim Holmes of Vanguard

Rob: Tim, welcome to the show.

Tim Holmes: Thank you Rob. Glad to be here.

Rob: I really appreciate you taking time out of the day to talk to us. Annuities are a topic that a lot of folks write me about and I think, frankly, I know just enough to be dangerous when it comes to annuities, so having someone from Vanguard to help us sort through this is great. So, why don’t you, just as a start, give everyone a little background about you and what you do with Vanguard.

Tim Holmes: Sure. My name is Tim Holmes. I’m principally responsible for Vanguard annuity and insurance services. I’ve been with Vanguard for over 28 years and the last four in the annuities business.

Rob: Okay, and what does your background look like that eventually led you into the annuities business? How does one get into that business?

Tim Holmes: Well, I’ve worked in many different departments at Vanguard, predominantly on what we would call the retail side of our business, so the direct-to-consumer business side of our business. Several years in our brokerage business and several years in our mutual fund business more broadly. And, again, now in our annuities group, again dealing with the same direct clients. And, particularly, at Vanguard, as you can imagine, the clients that we talk to that are interested in annuities typically are Vanguard Mutual Fund clients first. And, they are either looking for guaranteed income or they might be looking for additional tax deferral opportunities and would be referred to our group typically from the Mutual Fund folks.

Rob: Okay, good. Why don’t we kind of start at a basic level here and kind of just describe for us at a high level what an annuity is.

Tim Holmes: Sure, I’ll put them in two categories or buckets if you will. The first would be a deferred annuity which is really for saving for retirement or the accumulation phase. And, there are different types of deferred annuities. They can be deferred variable annuities which we offer, where the underlying investments are Vanguard Funds and it works very much like a traditional IRA would work. You invest, save for retirement, and you either take it out in a lump sum or in increments once you’re in retirement. What makes it an annuity is it has a feature that allows you to annuitize or convert that balance into a lifetime income stream that you can’t outlive. So, in other words, the payments would continue for the rest of your life and your spouse if you choose. With a deferred variable annuity, at some point in the future, you can decide to convert it to that income stream. Historically, though, we find that clients are really using it for the tax deferral and treating it much more like an IRA and taking it out either through withdraws or in lump sums as they get into retirement. And, that’s how those products have been used for years. What you really need to look at in those products are the fees. Just like with most investments, costs really matter. And, then, in the late 90s, the industry added what are called ‘income riders,’ or ‘living benefit riders’ to these products. A simple way to think about it is, I think of it as drawdown insurance. So, you’re in retirement— for an additional fee, you can guarantee that you’re drawdown strategy, depending on your age, 4 or 5 percent, will never be exhausted even if market conditions exhaust your portfolio.

Rob: Okay, and at Vanguard, is that something that is similar to what you call guaranteed lifetime withdrawal benefit?

Tim Holmes: That’s exactly right. GLWB is kind of the common term for it. And, it’s just a bolt onto that savings vehicle that allows you to ensure that if something were to happen in the market or the sequence of returns were such that your portfolio was depleted, you would continue to still receive your payments.

Rob: Let me kind of back up for a second, just so I understand, because you’ve given us a lot of great information and I want to make sure I understand it and those that are listening do. So, when you think of annuities, you kind of put them, if I understand it into two buckets. One of them is an annuity you might buy while you’re still putting money aside for retirement.

Tim Holmes: Yes.

Rob: You’re working, you’re not retired, you’re saving for retirement. An annuity might be something you’d want to consider to help you do that. So, that’s an annuity for savings— for retirement savings.

Tim Holmes: Right. And the caveat I would say, is you’d first want to make sure you were maximizing contributions to your 401K or any employer plan available as well as an IRA. If you’ve exhausted those and can’t contribute anymore from a tax-deferred basis, then you might want to consider an annuity to get additional tax deferral.

Rob: Okay, so that’s one sort of bucket we’ll talk about. And, the second bucket, I take it is annuities for income where you’re in retirement and you want some guaranteed income, perhaps, above and beyond social security or any other pensions you might have? You want some guaranteed income during retirement. That would be sort of the second bucket of annuities that you might consider, right?

Tim Holmes: Exactly right. The income annuity is what people typically think of when you hear the term annuity, where, in the simplest terms, you give a lump sum of money to an insurance company and in exchange for that they give you a lifetime income stream, a monthly check or quarterly check for the rest of your life. Those are called single premium immediate annuities and the term immediate just means I give the insurance company a lump sum of money, they start paying me now. There are other flavors of income annuities where you can defer the payments and such, but in its simplest terms, that’s how they work.

Rob: So, when we’re talking about annuities during the accumulation years, during the years you’re saving for retirement, you’re typically looking at a deferred annuity?

Tim Holmes: Correct.

Rob: So, let’s talk about annuities for savings for a minute and then we’ll go to annuities for income. If I understand the basic ideas, I set up a deferred annuity, which I’m going to contribute monthly or quarterly or annually or whatever to this deferred annuity— I’m going to be adding money to it?

Tim Holmes: Correct.

Rob: And, I’m not going to be taking any income at this point— like an IRA or 401K… I’m just going to let my investments grow while I’m working inside of this deferred annuity?

Tim Holmes: Exactly correct.

Rob: It sounds like if I’m at Vanguard, I could invest the money not unlike I could in a Vanguard IRA. I could pick the Vanguard Mutual Funds or, I suppose the ETFs, to invest in inside this annuity.

Tim Holmes: Right. Within our product there’s 17 different Vanguard funds that are actually separate insurance funds from what you do— they have to be separate from a regulatory perspective, but we basically just model them after very specific Vanguard funds and much like an IRA, you can exchange between the fund. And, as long as you’re within the annuity, none of that is taxable.

Rob: So you have, for example, I’m sure there’s some kind of S&P 500 Index Fund in the annuity that you can choose from?

Tim Holmes: Right. Exactly right.

Rob: And you have bond funds, international funds, that sort of thing?

Tim Holmes: Correct.

Rob: So, once you get to the point of retiring, you have a choice to make with what you’ve got in this annuity. You could— if I understand you, one option would be to an effect, convert it to an immediate income annuity. Say, okay, I’ve amassed all this money, a million bucks let’s say, that’s grown in this annuity for the last X number of years you’ve saved. I’ve got a million dollars and I want to convert some or all of this into an income annuity that will now start paying me money every month or quarter or whatever for the rest of my life.

Tim Holmes: Yes, and because that feature exists is why the annuity receives that preferential tax treatment. It allows you to accumulate those assets on a tax-deferred basis.

Rob: So until now this annuity has really not seemed very different from an IRA at Vanguard. It’s when you get to retirement that you’ve got this new option. I can convert this to a guaranteed stream of income during retirement. And, I take it you could convert some of the money or all of it?

Tim Holmes: Yes, that’s right Rob. That said, that’s not what most people do. Most people really purchase the annuity for the tax deferral. They treat it much like they do a traditional IRA where they take funds out as needed and pay taxes as they take them out. And, it’s important to note that for a non-qualified annuity— so any of the earnings that accumulated in that tax-deferred vehicle are taxed as regular income as they’re paid out to you.

Rob: Okay, just like an IRA or 401K?

Tim Holmes: Exactly right.

Rob: Now, with these deferred annuities for savings, I take it, as you said, typically you want to max out your 401K and/or IRA first before you might even consider saving additional money in a deferred annuity. So, I take it then, what the money that’s going into the annuity is after tax money?

Tim Holmes: Yes, there would be really no reason to take an IRA and put it into a deferred annuity for that purpose, because you already have the tax deferral obviously, if it’s an IRA.

Rob: So the tax advantage you get is that as your investments earn dividends and capital gains, perhaps, you’re not paying tax on that portion of the annuity. That can get deferred until you retire?

Tim Holmes: Exactly right. Now, for us, what’s I guess a common business for us is— annuities are sold. So, individuals purchase an annuity and might not quite understand what they have or might not quite understand the costs within that annuity. And, in the insurance business there’s a process called 1035 Exchanges. It’s very similar to an asset transfer where you can take an annuity at one firm and move it to another and as long as it’s going into another annuity. It’s not taxable and the tax deferral continues with the new provider. What we’ve found at Vanguard is— obviously Vanguard clients are sensitive to cost and they find that if they’ve bought an annuity somewhere along the line, they’re not quite sure what it is so we talk to them. We go over what the features and benefits are and what the costs are and help them figure out does it makes sense to move it to a lower cost annuity.

Rob: So they’re just transferring it from one financial institution to another— in this case, Vanguard.

Tim Holmes: Exactly. I bring that up because, for your listeners, a lot of them probably own an annuity and they may or may not fully understand what the benefits are. Is it purely for tax deferral? Does it have some debt benefit features? Does it have some income riders? And, it’s really important that you understand what you bought and what are the features and benefits and which ones are important to you. And, make sure you’re not paying for a feature or benefit that was added on and not really important to you.

Rob: Right. And, I take it if they wanted to, they could call Vanguard and talk to someone there about all of the issues you’ve just described as far as possibly transferring your annuity from another institution to Vanguard and what they have and what they want and that sort of thing?

Tim Holmes: Absolutely. Out on our website we have a calculator— the data comes from Morningstar, and you enter the information about your annuity and it compares it to the Vanguard annuity. As you can imagine, it tells you how much you could actually save each year. It also tells you if your annuity is in a surrender period with the other provider, which is helpful. I bring that up because that’s probably 60 percent of the people we talk to. We’re talking to them about an existing annuity and helping them lower their cost.

Rob: Let’s talk about that briefly before you move off of annuities for savings and go to annuities for retirement income, although I guess this may apply to both. I take it that, even at Vanguard, are there are fees over and above the cost of the funds inside of an annuity?

Tim Holmes: Yes, and they’re called mortality and expense charges.

Rob: Really? You guys couldn’t come up with a snappier name than that?

Tim Holmes: Thank the insurance agency. And what it is, is because you have the ability to convert that into a lifetime stream of income at some point in the future, insurance regulations require that the insurance company is reserving capital to make sure they can do that. So there’s expenses associated with the insurance aspect of that contract. Even though most people buying that product may not have bought it for that guarantee. It’s important— when you look and think through annuities, is that additional cost worth the tax deferral benefit?’

Rob: At Vanguard, what are those fees for, say, a deferred annuity, a variable annuity?

Tim Holmes: The additional charges above the fund expenses is about 29 and a half basis points.

Rob: Are the fund fees comparable, like, for an S&P 500 Fund inside an annuity? Are the expense ratios for that fund comparable to the Vanguard S&P 500 Fund outside an annuity?

Tim Holmes: Yes.

Rob: Okay, so you’re basically just paying just under 30 basis points for, in effect, this tax advantage you get for deferring the tax on your gains while the money’s in the annuity?

Tim Holmes: Correct. So then it becomes— it’s a matter of how long you hold the investment to determine whether it makes sense or not. So, typically, we would say it should be 10 years or longer, otherwise, you’re paying for that tax deferral and not reaping the benefit. And, it also matters what the underlying funds are. As you know, some funds are more tax efferent than others so you certainly see more tax-inefficient funds and types of funds within annuities, just because you don’t have to incur the taxes every year and get the benefit of a deferral.

Rob: Okay. That was actually my last question before we move to annuities for income because I was going to – sort of playing the devil’s advocate— why get an annuity? Why not just invest in tax-efficient investments that don’t throw off a lot of dividends and capital gains? I take it there’s certain asset classes? And I guess an extreme example would be a REIT that throws off a good chunk of income every year.

Tim Holmes: That’s a really good example of a fund that is less tax evidence than some others that the holding period. In other words, the break-even point where you’re better off in the annuity, is much shorter than it would be for something that is very tax efficient. Something like the S&P 500 is going to be more tax-efficient.

Rob: What classes of investments do you think are more ideal for annuities? We mentioned REIT, but would bond funds also be?

Tim Holmes: That’s exactly right.

Rob: Anything else?

Tim Holmes: Bond funds and anything that’s, either the portfolio has — and this is typically not Vanguard portfolio’s funds that have high turnover within the portfolio that create capital gains at a high pace or funds that have bonds or high yielding stocks or high dividend paying stocks. Basically, it’s just an equation of how long you’re going to hold it and the tax efficiency. Even for the most tax-efficient funds, you could still get the benefit of being in an annuity. You’d just need to hold it a longer period of time for that tax deferral to overcome the cost of the annuity.

Rob: Is there a calculator that determines that? Here’s how tax-efficient or inefficient my investment is and this is the cost of the annuity, the break-even point.

Tim Holmes: I haven’t seen a calculator, per se. I’ve looked at specific funds historically. And depending on the person’s tax bracket and such, we usually generally say the 10 to 20year period— you want to be in that range, if not longer. Certainly, if you’re younger and saving for retirement, sometimes those time horizons are much longer than 10 to 20 years.

Rob: Is there an age, like with a 401K and an IRA where you’ve got to start taking money out, the required minimum distributions at, whatever, 70 1/2. Is there a similar requirement with an annuity?

Tim Holmes: No, not with the non-qualified funds that are put in. If you had an annuity that was funded with qualified assets— let’s say an IRA and you bought the annuity because you wanted the guaranteed piece, that we’re going to talk about in a minute, then RMD would apply to this.

Rob: Okay, well let’s do that then. Let’s move to annuities for income. Someone listening here may be nearing retirement and may be wondering, “Should I buy an immediate income annuity with a portion of my nest egg?” What are the factors that one should consider when they think about that question?

Tim Holmes: The way we like to think about it is, think about whether you need more guaranteed income than you’re already going to get in retirement. We’re all going to get social security which is basically an inflation-adjusted annuity and we may have pension income. So take a look at the guaranteed income that you expect to receive and look at your level of non-discretionary expenses— expenses that you know are not going to be recurring. Is there a gap? You may want to consider filling that gap with another guaranteed income source which could be provided with an annuity. That’s kind of the simple way to think about it. Personal situations can be a little bit more complicated, so what’s discretionary to one investor may be non-discretionary for another. Is that place in Florida for winters— is that discretionary or non-discretionary? The other fact is that the ratio of discretionary to non-discretionary expenses can change throughout retirement. So, particularly if you end up being in an assisted living facility, you’re going to have a much higher level of non-discretionary expenses than you probably had when you first retired.

Rob: Thinking this through, if someone were to buy an income annuity at retirement… Let’s say they put half a million dollars, used a half-million dollars to buy an income annuity. That would guarantee them a certain amount of income every year until they passed away. Is that how it works?

Tim Holmes: Yes. That’s it, in its simplest terms. Now, there are other benefits and features that you can add on, so I could opt to have that income stream last throughout my lifetime or my spouse’s. If I pre-deceased my spouse and I want those payments to continue, I can add that feature. It’s the last surviving spouse that continues to get the income. You could also have the payment adjusted for inflation. There would be a CPI adjustment every year, so instead of a fixed payment you could have it so it increases with inflation. And, then more recently, we added— we have an income annuity platform called Annuity Access. We started to offer two different types of annuities. One is called deferred income annuity which is very similar to the immediate annuity. But instead of having the payments start immediately, you elect to have them start sometime in the future. So, imagine I’m 58 and I want to have a $1,000 a month of income when I retire at age 65. I could buy that at age 58 and it’s going to be cheaper for me to buy at age 58 than it would for me to wait until I’m 65 and purchase it. So that’s called a deferred income annuity. And, there’s been more and more discussion about these products as a planning tool, because you can deliberately set a retirement date and plan now to have income that starts when you retire and at least takes that portion of your nest egg of the table from the market perspective and know that you’re going to get that income. Then the last category of income annuities, which is kind of the more extreme, is what we call longevity insurance. That’s that same deferred income annuity, but the income start date is well in the future. In our scenario— in our product, it’s age 85. So, if I’m age 65 and my main concern is that I look around my family and I see people in their 90s and I’m worried about (in a good way worried) about my own longevity, that I could outlive my assets. Longevity insurance allows you to mitigate that tail risk and have income start at age 85 and then that helps with, okay now I know my portfolio, I know I really can focus on the next 20 years— 65 to age 85. If I’m fortunate enough to make it to age 85, this other source of income kicks in.

Rob: Let me just run through what you’ve just said, because I think it’s really important and make sure I understand it too. So if I were to buy a single annuity, income annuity at retirement, just for me, and whatever— I put a million dollars into this annuity and it guarantees me X dollars a month or year in income and I’m happy and I get hit by a truck two weeks later and I die, that money’s gone, right? I don’t pass that on to my beneficiaries.

Tim Holmes: That’s correct. And that’s the biggest hurdle for investors to get over in buying an immediate annuity. If I don’t live to my life expectancy, do I quote-unquote lose to the insurance company? And, it’s why the insurance companies can pay out fairly attractive rates, because it’s risk pulling. So, for everyone who lives into their nineties, there’s probably someone who passed away in their 60s or 70s. Those that live long benefit from those that don’t. Similar to any other insurance product, I buy homeowners insurance. If I have it and I need it, I’m benefitting from those that never had a claim.

Rob: Right. An annuity is an insurance product. So, I’m giving up certain benefits of keeping control of my money, for example, deciding I want to spend it all right now, for example, instead of waiting each year for the annuity to pay my income. And, I’m also giving up, potentially if I were to pay away early, the benefit of I won’t have that money to give to my beneficiaries— that’s sort of the downside. But the upside is I’m getting a level of security of I’m getting this money that I can count on the rest of my life.

Tim Holmes: That’s right. There’s a peace of mind benefit. That’s hard to quantify what that is, but when we talk to investors, that’s pretty important to them to know that no matter what else happens, if I bought this annuity, I know I’m going to get X amount for the rest of my life. Particularly if it’s a joint annuity with my wife. I know that whatever happens we have an income stream, even if there’s a recession and the markets perform poorly, we still have some level of guaranteed income to meet our most basic needs.

Rob: Okay, that makes sense. And, kind of just going down your list that you went down a minute ago— with a joint annuity, it wouldn’t last just until I passed away, but also until my wife passed away, is that the idea?

Tim Holmes: That’s correct.

Rob: It’s obviously a good thing in terms of income security for a couple. I take it the benefit for the same $5,000 would be lower? The annual income would go down?

Tim Holmes: Correct.

Rob: That makes sense. Or, put differently… If I wanted a $5,000 a month benefit, the cost to buy that would go up with a joint annuity?

Tim Holmes: That’s correct. It also depends on your age and your spouse’s age.

Rob: Sure. The older you get, the cheaper it gets.

Tim Holmes: That’s right.

Rob: Then the CPI adjustment, inflation adjustment, again, you can add that— but that’s also going to cost you more?

Tim Holmes: That’s exactly right.

Rob: You’re insuring against the risk of runaway insurance.

Tim Holmes: That’s right.

Rob: Okay. And, then, okay, that makes sense, you mentioned the deferred income annuity. Again, the idea is the sooner you buy it, say when you turn 65, it’s going to be cheaper, because effectively, the insurance company has more time to invest your money and build up a pool of assets that they can then use to start paying the income payments when you turn 65.

Tim Holmes: That’s right. And, if you look on our web pages, we do give an example of the cost of $1,000 a month of income at age 65 if you want that income to start immediately. For example, someone on the website— the example is someone 65 who wants payments to start immediately at $1,000 a month. That would cost $167.

Rob: Okay, that’s today’s price. That price— I assume it fluctuates?

Tim Holmes: Yes, it fluctuates. However, let’s say I decided, you know I’m 65 but I don’t need those payments to start until I’m 75. I’ll rely on my portfolio. That same $1,000 a month— you’d need to invest 77,000 roughly. And then, the extreme example would be longevity insurance. If I want that $1,000 a month and I don’t need it to start until age 85, that may only cost me $27,000.

Rob: Alright. Well, that’s helpful to see the difference based on the number of years until you want to use the money. One thing I’ve read is that the cost of an annuity really is affected significantly by interest rates. Is that accurate?

Tim Holmes: Yeah, I mean, there’s a number of factors, but interest rates certainly are a big component. The insurance company is investing those assets in their general account and a lot of the securities used are treasuries so the interest rates on treasuries have a big impact. The other dynamic is also mortality tables. So, those tables are updated on a regular basis, so as life expectancies get longer, the payments will be lower for the same annuity.

Rob: Because we’re living longer.

Tim Holmes: Exactly right. So, there’s a couple of dynamics at play there and we’ve particularly, with interest rates where they are now, we have investors that we talk to that are trying to figure out should I wait, should I buy now and we one way to do it is to— kind of similar to dollar cost averaging in purchasing a mutual fund, you can dollar cost average it and buy an immediate annuity every year for the next four years or something like that for smaller amounts if you’re concerned about interest rates rising in the future. Although, again, if we had this conversation a few years ago, interest rates haven’t risen, so, as you know, it’s hard to predict.

Rob: I predicted they’d go up about four years ago, so that tells you how good I am at predicting.

Tim Holmes: And, Rob, eventually you’ll be right. Eventually, they will go up.

Rob: You know, they say an economist should predict what or when, but never both, so there you go.

Tim Holmes: I like that.

Rob: So with a fixed income annuity, where you buy it, you get the income for life and the retirement. I take it that kind of annuity, you’re not managing investments and picking funds. You’re just giving Vanguard or whoever you choose whatever— $100 and in return you’re getting income for life.

Tim Holmes: That’s right. There are a couple of exceptions. There are products that are not really common anymore called variable immediate annuities where your payments can change based on the underlying vested investments that you direct, but I think that those are becoming less and less popular.

Rob: Okay, well, so someone in retirement. A couple things here, just so we kind of cover the landscape. Someone’s nearing retirement and they’re thinking about possibly annuitizing some of their nest egg. I think a couple things – they don’t have to do it right now if they don’t want. If they’re 65 and retiring, they could wait and do it whenever, I guess.

Tim Holmes: Absolutely. The other thing, when you first retire, you might not know what your lifestyle is going to be like in retirement. You may envision it, but many people that I know retire and a few months later they’re back in the workforce, because it wasn’t the right time.

Rob: And, then I take it they could, as you mentioned, they could buy, it’s not an all at one time kind of thing. They could buy $100,000 in annuity this year and another $100,000 next year and spread it out over a number of years if they wanted to.

Tim Holmes: That’s right. So, what we would talk to them about is what really is their income need to try to figure out if an annuity even makes sense. We would also want to make sure that they weren’t investing their whole nest egg in an annuity. On average, the income annuity purchase that we see here at Vanguard is around 20 percent of someone’s portfolio being used.

Rob: And, why wouldn’t you want to see someone use all of their portfolio to buy an annuity?

Tim Holmes: Because you want to have access to assets in case of an emergency or you may have a need for liquidity because of the healthcare issue. Or, any other number of things— you want to help out a family member. We would suggest… Typically it ends up in that 20 percent range.

Rob: So, if someone had a million dollars, if they were going to buy an annuity and they followed the average what you see, they’d buy an annuity for $200,000?

Tim Holmes: That’s right.

Rob: Now, what happens if that money they’re going to buy the annuity with is in an IRA or a 401K and they want to buy an annuity? Does that create any tax issues for them?

Tim Holmes: No, it doesn’t. It’s moved into the annuity. There’s no taxes when you actually move it into the annuity, but there are as you get payments. Just like in an IRA, that income stream would be taxed at ordinary income tax rates.

Rob: Would the annuity actually stay inside the IRA?

Tim Holmes: Yeah, it would be called an IRA annuity. So, basically the tax treatment— the IRA rules are still enforced, if you will, for that contract so any RMD requirements and so forth would still be there. Although, for an immediate annuity, because you’re being paid out based on life expectancy, by definition you’re meeting the RMD requirement. Does that make sense?

Rob: It does. It’s just another way of saying if you take IRA funds and you use them to buy an annuity, you don’t have to worry about the RMD, at least as it relates to that portion of your assets.

Tim Holmes: Exactly right. Very good point.

Rob: You’d have to pay the RMD on whatever you have left, I assume, in an IRA or a 401K?

Tim Holmes: That’s right.

Rob: Okay, one last question and I appreciate your patience as I try to understand all of this and pummel you with questions. I take it one should shop around. If I’m going to annuitize $250,000 with a fixed income annuity, I may get different income amounts depending on whether I shop at one financial institution or another— it’s not all the same everywhere?

Tim Holmes: Absolutely. We have a platform called annuity access where there’s actually multiple insurance companies on the platform that bid on your business for lack of a better term. The requirement is that they’re bidding on an apples-to-apples basis. The investor puts in what they’re looking for— their age and if they want the spousal feature or not and then within seconds you get quotes from the insurance companies and it allows you to do an apples-to-apples comparison. Without a platform like that, it becomes a bit challenging because you have to know what features you’re comparing. Like with anything else, if you’re comparing cars, if you compare a model that has all the features and bells and whistles with a similar model without those, there’s going to be a difference in price. It’s the same with annuities. If you compare them, make sure you’re comparing apples to apples.

Rob: Okay, good tip. So can anyone, or maybe it’s just Vanguard clients, but can anyone go in and look at this platform and put in their information and get an idea of how much income they’d get if they annuitized X dollars from their nest egg?

Tim Holmes: Absolutely. If they go through the Vanguard website and go into the annuities section and go under the income annuities, there’s a link that takes them to a site where, if they’re not a Vanguard client, they would need to create a profile. Then that profile would be used to get quotes based on their age and so forth.

Rob: I actually see that now. I will leave a link to that in the show notes for folks. I also see the table that you mentioned where to buy a $1,000 of income for life if you’re 65 and you want to start receiving it today, it would cost you $167,000 and then it changes if you want to defer it for any number of years. That’s helpful. I’ll leave a link in the show notes to that page as well for folks so they can check that out.

Tim Holmes: And, with any of these guaranteed income products, you want to think about your own longevity. Is that a concern? If longevity is not a concern for whatever reason, products may not make sense for you. We have those discussions with clients. Also, how important is leaving a large sum to your heirs? Because once you turn that money over to the insurance company, your heirs are not going to get that back. So, it’s a balance of walking through what your priorities are and we would help someone figure out if an annuity makes sense for them and, if so, which type.

Rob: Good, okay.

Tim Holmes: But, Rob, the last category we didn’t talk about and I’ll leave it up to you if you want to delve into it at all, but these living benefit riders or what are called GLWBs that are added to the variable annuities. I think about 70 percent of variable annuities sold today have this feature. And, it’s, as I described earlier, it’s this drawdown insurance. All I would say on this is it’s very important to understand what features exist within the product, what the payout rates are, etcetera and how much you’re paying for them. Because those guarantees can bring the total product cost into the 2-3 percent range, if not higher. That’s really important to understand, it’s great you got this guarantee on your drawdown, but the cost of the guarantees, if it’s 3 percent, is going to deplete your nest egg pretty quickly.

Rob: Well, let’s just take a minute to look at that. You talk about drawdowns and a variable annuity so the guaranteed lifetime withdrawal benefit, it applies to someone who’s purchased a variable annuity that they’re using to save for retirement?

Tim Holmes: Correct We see people interested in the product during the savings period, but really pre-retiree, a few years before retirement, where they want to lock in a level of income and mitigate the risk of a market downturn just before they retire.

Rob: I see. We had just been talking about a fixed income annuity in retirement— that doesn’t apply to that kind of annuity.

Tim Holmes: Correct.

Rob: Alright, so we’re talking about a variable annuity, where you’re saving for retirement. You’re, at that point, exposed to the risk of market declines, just as you would if you were investing inside an IRA or a 401K or a taxable account. The market could tank over the next couple of years, right before retirement when you can least afford for the market to go down.

Tim Holmes: Right. So, for our product, for example, if you’re between the ages of 59-64, you can lock in a 4 percent drawdown guaranteed for life, 4 percent of the current balance. And, that drawdown amount, the longer you wait until you start taking drawdowns, the higher that is. Once you reach age 65, it’s 5 percent guaranteed for life and it can go up if the market value or the portfolio value goes up because of the market’s gone up.

Rob: Well, help me with this. When we were talking about variable annuities for the saving phase of retirement, you mentioned that when you hit retirement you can annuitize all that money, but most of your folks don’t actually do that. They just treat it like an IRA or 401K and withdraw money from the account in retirement as they need it, right?

Tim Holmes: That’s right. The big attraction of the GLWB is, unlike annuitizing your variable annuity once you retire, adding the GLWB still gives you access to the underlying assets and those underlying assets are still invested. So, your plan might be to take 5 percent out of the rest of your life, but if you have this in the GLWB and your circumstances change and you need to get fifty thousand dollars out of that annuity, you can get it out. Now, that’s going to change the guaranteed amount going forward, but it gives you the flexibility that, unlike an income annuity, you’re not turning over the whole lump sum to the insurance company, so it’s not irrevocable.

Rob: It’s interesting. It’s almost like a hybrid. Like an annuity, you’re getting a guarantee. It’s different though. You’re getting a guarantee based on a percentage of whatever asset you have in this variable annuity.

Tim Holmes: That’s exactly right. And, as I said earlier, thinking of it as drawdown insurance is the way that I got to understand it. Just like any other insurance, I don’t really want my portfolio to be exhausted. I don’t want a tree to fall on my house but I still pay my homeowners insurance. I know I have the peace of mind that if the sequence of returns in the markets results in me not being able to maintain those drawdowns, the insurance company kicks in and continues to pay me. It’s very much insurance and you really have to weigh is the cost of that insurance worth the benefit to you.

Rob: So, if I had a million dollars and I wanted guaranteed lifetime withdrawal benefit that guaranteed me, say a 4 percent withdrawal, depending on my age and whatnot, that would be a certain cost, obviously, but then it would guarantee me a minimum of $40,000 a year in income from my one million dollars for life?

Tim Holmes: That’s right. That could never go down, but it could go up. If next year, because your portfolio has done well and your portfolio is now worth one point one million, it would be 4 percent of that.

Rob: I would continue to get that $40,000 even if, because of market conditions and maybe if I lived a long time, I would’ve eventually depleted all of my one million dollars.

Tim Holmes: That’s right.

Rob: One of the benefits to this, over an annuity, is that if I get hit by a truck a month later, my family still has this million bucks that was sitting there. It didn’t go to the insurance company.

Tim Holmes: That’s right. Your beneficiary receives the assets.

Rob: Well, hopefully I’ll be able to link to all this. I’ve been taking copious notes during this interview Tim.

Tim Holmes: I hope I didn’t go all over the place, but thank you very much.

Rob: I won’t tell you this is the easiest topic in the world to get our hands around, but we’re doing our best and hopefully those folks that are listening— by the way, Tim, they’ll let me know if they have questions because I get a ton of e-mail every day and maybe I’ll shoot some to you and the folks at Vanguard or just have them contact you directly. But, this has been very helpful. Have we missed anything? We’ve covered a lot. Is there anything else we should cover before we call it a day?

Tim Holmes: No, I think we touched on a good bit— you’re right, it’s a complex category and the insurance companies are very innovative in developing products and features that meet client needs. That’s the plus. The downside is it complicates things quite a bit. So, if you own an annuity, figure out what it is and how much you’re paying for it and hopefully the benefit is what you’re seeking. If not, give us a call and we can help.

Rob: Good. Alright, Tim, well thank you so much for your time today.

Tim Holmes: Thanks Rob, I really appreciate it.

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  • Rob Berger

    Rob Berger is the founder of Dough Roller and the Dough Roller Money Podcast. A former securities law attorney and Forbes deputy editor, Rob is the author of the book Retire Before Mom and Dad. He educates independent investors on his YouTube channel and at